About six months from today, the European Union is scheduled to implement MiFID II, imposing a punishing regulatory burden on any firm engaged with the European markets. This ironic turn of events, given the current administration’s efforts to turn back the tide of regulation, clearly shows MiFID II to be at least one drawback to globalization.

What’s the Fuss?

Under MiFID II, funds are required to disclose research cost to their investors. In current business practice, equity research costs are addressed under the broader context of trading fees. This has become quite a sticking point for the sell-side universe, which is wont to place a much higher value on their research services than the buy-side community is willing to pay. This divide holds the promise of inflicting havoc in the research analyst profession and many investment banks have already made personnel cuts in anticipation of reduced demand. In February 2017, CLSA Americas LLC, a leading brokerage and investment group, addressed the problem by announcing its intent to focus exclusively on providing execution and trading services, eliminating the research component of its business.

Another thorny problem arising from MiFID II revolves around the requirement that all interpersonal contacts between funds and their clients be recorded. This includes cell phone and landline calls, texts and face-to-face conversations. It doesn’t require much of an imagination to see the spectrum of challenges hedge funds must meet to satisfy this aspect of MiFID II.

The Second Issue

The banking industry, having learned nothing from its subprime mortgage debacle, is perpetrating what some have described as “Carmageddon” on the investment community. So-called “liar loans” packaged into mortgage backed securities ultimately resulted in the 2008 financial crisis.

As a result, regulations were promulgated requiring lenders to verify income, employment and other factors to better assure the ability of debtors to repay their loans. However, these regulations hold no sway over auto loans. As a result, the subprime auto loan backed securities market is booming.

Unfortunately, delinquencies are increasing at an alarming pace. This, coupled with falling used car valuations, threatens the solvency of these securities in much the same way mortgage backed securities collapsed during the financial crisis.

While this cannot be laid at the hedge funds industry’s doorstep, any hedge fund profiting from this unfortunate situation is sure to be vilified in the financial media.

Final Thoughts

Small to medium-sized hedge funds are the least likely to be in a financial position to meet the onerous regulatory burden that MiFID II represents. Even the largest funds will be forced into substantial expenditures to achieve compliance. Smaller funds may be forced out of European markets to survive, while others may opt to close their doors. Whatever course of action is chosen, MiFID II will be a sea change for the hedge fund industry.

The potential profits represented by shorting subprime auto loan backed securities have the potential to be huge. However, any hedge fund venturing into this space must weigh the fallout sure to result from engaging in this tranche of business against the gains that may be achieved.

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